Kinder Morgan, Inc.

KMI
May 29, 2014

$33.60

Investment Summary

Kinder Morgan owns the largest natural gas, petroleum, and petroleum products pipeline and terminals network in the U.S., operating 80,000 miles of pipelines and 180 storage terminals. Kinder Morgan’s vast and diverse asset footprint connects to every important domestic natural gas resource play, and the company charges customers volume-based fees (with minimal exposure to commodity prices) for the natural gas and refined products that flow through its pipelines and terminals. Kinder Morgan’s competitive position is extremely strong given the size and breadth of its network, providing an advantaged position from which to spend capital at attractive returns as well as reducing the risk that a particular supply shift decreases the volume of product flowing through the company’s pipelines. CEO Rich Kinder has run the company since its founding in 1996 and has a tremendous track record of creating value for shareholders. With respect to strategy, operations and capital allocation, Rich Kinder has been one of the most successful CEOs in the history of energy. With a 5.1% dividend yield, likely 10%+ future cash flow growth, a low-risk / high-quality business, and a superb management team, an investment in KMI through a combination of stock and in-the-money 3-5 year LEAPS will likely generate compelling returns over a 5 year period with minimal risk of capital loss.

KMI and the GP + MLP Structure

KMI owns the general partner (GP) interest in two underlying limited partners (LPs): Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB). Although KMI’s ownership structure is complex, note that KMI simply collects cash flows from its ownership interests in these two companies. The GP/LP structure is extremely advantageous to the GP if the underlying LP is growing because, as the LP’s cash flow grows, the GP is paid a higher percentage of those cash flows without putting up any additional equity. Thus, the return on capital for the GP is essentially infinite and the cash flow growth is ~2X that of the LP.

To be clear, we are recommending an investment in KMI, which is structured as a c-corp. The underlying LPs are structured as master limited partnerships (MLPs), providing nice tax benefits to those owners and reducing those subsidiaries’ cost of capital.

MLPs have an advantaged tax structure because Congress wants to incentivize more investment in U.S. energy infrastructure.  There is no corporate tax, and the distribution is largely tax deferred until the owner sells the units. MLPs are very similar to REITs in that both must pay out most of their net income.  (Note that this leaves a great deal of discretion to MLP management teams because net income is far below distributable cash flow.)  The main distinction between MLPs and REITs is the general partner (GP) structure.  A quirk of history is that energy MLPs have a graduated “splits” scheme whereby the GP is incentivized to grow distributions by receiving a higher percentage of the MLP’s distribution as that distribution grows, typically capped out at 50% of the MLP’s distribution.  For example, Kinder Morgan’s split scheme requires the MLP to pay 2%, 15%, 25% and 50% of its marginal cash flows to the GP for different levels of distributions. Thus, as the MLP’s distribution grows, the GP’s share of those distributions, which is termed incentive distribution rights (IDRs), grows dramatically.  Furthermore, as the GP’s share of the MLP’s distribution increases, the GP’s share of capital spending typically remains capped at 2%. Herein lies the true power of the GP: cash flows grow rapidly with essentially no capital required at the GP level, making the GP’s return on capital extraordinarily high. 

Note that KMP and EPB distribute 43% and 27% of their cash flows, respectively, to KMI through GP IDRs.

In addition to benefiting from increased distributions, the GP benefits when its underlying MLP issues equity units. For each equity unit issued by the MLP, the GP receives the IDRs for that unit. So as the MLP funds its capital investment program with equity, the GP not only benefits from the higher level of distributions, it benefits from the increased number of MLP equity units outstanding. 

The GP structure was originally put in place with the expectation that MLPs would have slow growth and likely never enter the high splits.  However, Rich Kinder figured out the significant value created for GP owners by growing the MLP’s distributions through an aggressive acquisition and capital spending program, and he was the first to pursue such a strategy at Kinder Morgan. Other MLP management teams soon followed.

The Midstream Energy Industry

Midstream energy pipelines and terminals are key assets in the energy value chain. Moving natural gas and refined products through pipelines is the most cost efficient mode of transportation. Unlike other management teams in the energy space (specifically in the E&P business), pipeliners have proven to be risk-averse, rational allocators of capital. Building pipelines and terminals is significantly de-risked as capacity is contracted with customers before construction begins. Long-haul, toll road-like pipelines are highly cash generative and great assets to own, and the need for additional midstream assets in the U.S. should provide strong growth for many years to come.

The development of hydraulic fracturing has driven an energy boom in the U.S. Fracking (blasting water, sand and chemicals into source rock) has released enormous amounts of natural gas, NGLs and oil from new supply fields. This energy boom continues to require more and more pipelines to connect the new sources of supply to end-market demand. U.S. dry gas production has increased from 55 Bcf/d in 2000 to 70 Bcf/d in 2013, a dramatic increase. Furthermore, this level of gas production may increase to 90+ Bcf/d over the next 15-20 years. Prolific supply fields, such as the Marcellus shale, as well as the exportation of LNG are transforming the pipeline infrastructure, and large, incumbent players such as Kinder Morgan are in the best position to capitalize on this opportunity.

The industry can be segmented by type of commodity: natural gas, natural gas liquids (NGLs), crude oil and refined products (e.g. gasoline and aviation fuel).  Another division is by a) interstate pipelines, b) intrastate pipelines and c) gathering and processing assets. Interstate pipelines are usually very predictable and regulated by the federal government (Federal Energy Regulatory Commission, or FERC) and are contracted at a fixed price with price increases as well as escalators for inflation. Intrastate pipelines have somewhat more variability depending on particular fields and/or refineries and are regulated by the states (e.g. the Texas Railroad Commission). Gathering and processing assets are more dependent on specific supply fields as well as carry some commodity price exposure.  Gathering and processing assets as well as some intrastate natural gas pipelines are seen as somewhat higher risk than interstate pipelines because they depend upon the health of the field of origin, but they also provide higher returns than the more regulated interstate pipeline assets.

The Business and Competitive Position

KMI owns GP and LP interests in KMP and EPB, both of which are well-managed midstream energy businesses with high quality, steady, fee-based assets. Currently, KMI is the owner of the GP and 12% of the LP units of KMP/KMR as well as the GP and 41% of the LP units of EPB. In 2013, KMI’s cash flow breakdown was approximately 75% from KMP and 25% from EPB.

Taken as a whole, the Kinder Morgan family of companies is the largest midstream energy company in the U.S. Given the market power that comes with scale, Kinder Morgan’s most significant competitive advantage is its size and reach. Kinder Morgan is the largest U.S. player in all of its midstream niches:

• #1 transporter of natural gas (by miles of transmission pipeline)
• #1 independent transporter of petroleum products (by barrels of petroleum product transported)
• #1 provider of contracted natural gas treating service (by gallons per minute of natural gas treating capacity)
• #1 transporter of carbon dioxide (by Bcf per day)
•  #1 independent terminal operator (by capacity)

Kinder Morgan’s entrenched market position is a significant competitive advantage when contracting for capacity additions given KMP’s and EPB’s incremental return on capital is much higher than a new operator’s return on capital (due to significant initial infrastructure costs). This opportunity to spend additional capital at very attractive rates of return (and very high returns for KMI, the GP) is what makes key infrastructure assets very valuable in key growth regions, such as U.S. natural gas and oil shales. In total, Kinder Morgan has over $16 billion in its capex backlog for the next 5 years, and we believe the project spending will likely be higher than that. Importantly, these are high quality projects with 87% of the backlog being fee-based pipelines, terminals and associated facilities.

The size and breadth of Kinder Morgan’s network not only provides an excellent base from which to spend incremental capital but also significantly diminishes the risk of the overall business. Should a new shale opportunity present itself in the coming years, the chance that changes in intercontinental commodity flows will adversely impact Kinder Morgan’s cash flows is very low considering that the company’s network touches essentially all sources of supply and demand already. In other words, it’s hard to go around Kinder Morgan’s network. For example, the large increase in natural gas supply from the Marcellus shale adversely impacted one of Kinder Morgan’s pipelines (the Rockies Express Pipeline), but the Marcellus’ growth also has enhanced the value and importance of Kinder Morgan’s Tennessee assets.

Kinder Morgan’s business generates very steady, predictable cash flows. KMI’s pipelines can be thought of much like a toll road, given the transport charges are predominately volume-based with limited commodity price exposure as well as structured through ~3 to 20 year contracts. Approximately 80% of KMI’s cash flow is fee-based while 93% is fee-based or hedged. The limited commodity price exposure comes from KMP’s natural gas processing unit and E&P assets associated with KMP’s carbon dioxide transport business. Note that 100% of EPB’s cash flow is fee-based. In fact, a key component of Kinder’s genius has been to aggressively operate and capitalize very safe assets.

KMP’s cash flow breakdown is below. Note that only 13% is generated from gathering and processing assets, which are less predictable than long-haul interstate and intrastate pipelines.

• 43% Natural Gas Pipelines
  • 24% interstate pipelines
  • 13% gathering, processing and treating
  • 6% intrastate pipelines and storage
• 25% Carbon Dioxide Transport and related Oil Production
  • 7% CO2 transport and sales
  • 18% oil-production related (~80% hedged in current year)
• 17% Petroleum Products Pipelines (including KM Canada)
  • 11% pipelines
  • 6% associated terminals and transmix
• 15% Terminals
  • 9% liquids
  • 6% bulk

EPB generates 100% of its cash flow from natural gas pipelines, with 89% from interstate pipelines.  

The El Paso Corporation was acquired by KMI in October 2011 in a $38bn transaction, or ~10X EPB’s forward EBITDA. At the time, El Paso consisted of the GP for El Paso Pipeline Partners as well as its own natural gas pipelines and production assets. The transaction created the largest midstream and natural gas pipeline company in North America and demonstrated KMI’s ability to leverage its unmatched scale and reach. EPB’s suite of fee-based interstate natural gas pipelines helped KMI diversify away from KMP's more commodity sensitive CO2 operations and the combined footprint of the two companies added significant organic growth opportunities. KMI and EPB’s asset networks overlapped only in the Rockies. 

KMI moved quickly to streamline El Paso’s operations by selling off the riskier exploration and production assets and dropping down El Paso’s operating assets into KMP and EPB. By 2015 KMI will once again consist almost exclusively of LP and GP interests and have the opportunity to potentially combine the EPB and KMP MLPs in the future.

Management

Rich Kinder is among the best CEOs in the entire energy sector. With respect to strategy, operations and capital allocation, he is excellent. His track record is truly extraordinary, generating over 30% compound annual returns for KMI shareholders since inception. KMP shareholders have received an annualized total return of 24%, an astounding figure when taking into consideration that KMP pays out 50% of incremental cash flows to KMI.

Kinder’s compensation structure is very appealing for shareholders. His annual salary is $1, and he receives no bonus, stock options or restricted stock. He has never sold a share of KMI stock. In fact, when he took KMI private in 2007, Kinder increased his ownership percentage from 18% to 24%. He also has a record of buying shares of KMI in the open market. Note that Kinder’s economic exposure is almost entirely in KMI stock. He owns 243 million shares of KMI and ~300k shares of KMP and KMR, which is an entity identical to KMP except distributes additional shares rather cash distributions in order to circumvent K-1 and UBTI-related tax complications for institutional shareholders. At today’s prices, Kinder’s KMI stock is worth $8 billion.

Kinder and the management team are focused on capital allocation and cost management. As expected, Kinder takes enormous pride in his business. KMP has met or exceeded its annual distribution guidance in 13 out of the last 14 years (and the miss in 2006 was by 2 cents per share). We have spoken with Kinder several times and think he is superb.

The senior management team under Kinder is strong and has a long record with the company. Note that several of these managers were recently promoted in 2013. Kinder requires a lot from his managers, who are rewarded if the company does well. The maximum cash salary for senior executives is $300k/year with annual bonuses paid based on the cash distributions paid at KMI and KMP.

Steve Kean is President and COO of Kinder Morgan. He joined the company in 2002 as Vice President of Strategic Planning for the company's Natural Gas Pipelines and was named President of the Texas Intrastate Pipeline Group that same year. Kean became Executive Vice President of Operations and joined the Office of the Chairman in 2005, and was named Chief Operating Officer in 2006. He also served as President of the Natural Gas Pipelines segment during 2008-2009.

Kim Dang is Vice President and CFO of Kinder Morgan. She joined Kinder Morgan in 2001 as Director of Investor Relations and was named Vice President, Investor Relations, in 2002, Treasurer in 2004 and CFO in 2005.

Price

KMI currently trades at a 5.1% 2014E dividend yield, which we believe is a significant discount to intrinsic value. The current price does not reflect Kinder Morgan’s competitive position within the growing U.S. energy infrastructure value chain. KMI’s steady cash flow stream and ability to grow with almost no capital expenditures (due to the GP/LP structure) make this a premier asset. Perhaps most importantly, this asset is run by a CEO whose track record of value creation is in the league of John Malone, Warren Buffett, and other great founder CEOs who have created enormous value. The current valuation of KMI does not appropriately factor in that Rich Kinder will likely continue to make attractive acquisitions as well as find high return on capital growth projects. As KMI shareholders, we will receive the dividend yield annually as well as the growth in that dividend over time, which together will likely generate attractive 5 yr returns with minimal risk of permanent capital loss.

Risks

Increased regulation. Kinder Morgan’s interstate pipeline rates are regulated by FERC and several unfavorable rate cases have impacted EPB’s cash flows. A decline in the allowable rate of return on pipeline assets could negatively impact Kinder Morgan’s cash flows. There are no active rate cases that would materially impact Kinder’s cash flows, however.

Increased competition for building pipelines and terminals. The bidding process for new pipeline and terminal projects is often competitive, and if competitors lower their return hurdles, that could lead to lower capital spending by KMP and EPB. Lower spending or spending at lower rates would lower the dividend growth at KMI.

Change in U.S. MLP tax treatment. An elimination of the tax advantage associated with the MLP structure would negatively impact the value of KMP and, thus, KMI. Additionally, any change in the tax treatment of GP IDRs could potentially have a meaningful impact on KMI. At present, there is no legislation on the horizon.

Rise in long-term interest rates. KMP and KMI are levered entities, so an increase in interest rates without an inflationary increase in revenues would adversely impact KMI’s cash flows. Additionally, a rise in long-term interest rates may negatively impact the price of KMI.

Decline in equity price of KMI’s underlying MLPs. The GP’s ability to grow is in part reliant on the LP’s ability to raise equity capital. If KMP’s and EPB’s stock prices decline meaningfully, their ability to issue equity would be hindered and, thus, KMI’s growth rate would likely decline.

Decline in oil prices. Kinder Morgan’s CO2-related E&P assets have direct exposure to oil prices. While the company has a policy to hedge against movements in the price of oil, sustained lower oil prices would have a negative impact on that segment of Kinder Morgan’s business. Note that only 7% of KMI’s cash flows are exposed commodity prices with the majority exposed to oil.

Catastrophic pipeline accident. While Kinder Morgan has a good safety record, a catastrophe could result in brand degradation and punitive damages. That said, the company has extensive insurance policies to protect itself financially from business interruptions.